Stocks: Cheap but best avoided

They seem to be available at a bargain, and hence, are difficult to resist. However, we at ETIG found that it’s best to avoid them. Read on to find out more about these hot potatoes.


When it comes to investment philosophy, the world is split down the middle. For, while one school of thought believes in “buying low and selling high” , there’s a big fan-following for the alternative “buy high and sell higher” . The former school generally compares the current valuations of a stock with its historical valuations and those of its peers to find out whether a stock is under-, fairly- or overly-valued . Once a stock is found to be undervalued, such investors then go and buy it, assuming that in the long run, the stock will rise to its fair valuation.

Although not as popular as the first one, the other school of thought believes in just the opposite. Being believers in the market’s efficiency, this group assumes that if the market values a stock higher than its peers or vice versa, there have to be valid reasons for it. So, the reason for a stock trading at higher valuations is that the market expects it to do better than its peers in the future and hence, is prepared to pay a premium for it.

And if a stock is available cheap, it is probably headed for dismal times. Therefore, we will be better off not questioning the judgment of the market. But why isn’t this investing philosophy very popular? The answer is simple. Human psychology is such that in the market, as even in our daily lives, we keep hunting for bargains, forgetting that “only rhetoric comes cheap, evidence is more dear.”

Notwithstanding the recent recovery attempts, the broader market in India has been totally battered and bruised out of shape. As a result, valuations of a large number of fairly good companies look very attractive — both as compared to their historical valuations and some of their peers.

But if we go by the second school, there’s every reason to believe that if these companies have found themselves to be out of favour with the market, their near-term future will probably not be that bright.
In order to help readers stay away from these, ETIG dug deep into the past five years’ data and ferreted out stocks, which although cheap, are best avoided.

In this analysis, we restricted ourselves to the BSE 500. Within that, we looked at stocks that are trading at least at a 50% discount to their five-year average P/E (priceto-earnings ) and P/BV (price-to-book value) multiple

This gave us around 45 stocks, out of which, we chose eight stocks across sectors. All of these look attractive at the first look, but a thorough analysis makes it absolutely clear as to why they are where they are. In fact, a few of these are available at historically high dividend yields as well, which in normal times should have made them that much more attractive.

NIIT Technologies: With the fanfare surrounding its spin-off from NIIT long gone, NIIT Technologies continues to find it difficult to create a niche for itself in the highly competitive IT services business. That it gets over 45% of its revenues from the BFSI (banking, financial services and insurance) space doesn’t help either, as a global financial turmoil means that shortterm growth is very challenging. Operating margin for the quarter ended June ’08 has taken a hit and is lower on both quarteron-quarter (q-o-q ) and year-on-year (y-o-y ) basis — validating these fears.

Mangalore refinery: The outlook for the entire petroleum refining industry, which enjoyed rising refining margins in the past few years, is slowly but surely turning negative. Moreover, the only product that would have allowed it to command a premium in the near future — Euro Grade V fuels — is still a long way off from flowing out of its refineries. It will take at least two years to complete Mangalore Refinery and Petrochemicals’ (MRPL) refinery upgrade and petrochemical projects. And since it’s now operating at nearly 130% of its rated capacity, even volume-led growth will be difficult to come by.

PFIZER: Over the past five years, Pfizer’s sales have witnessed a dismal compound annual growth rate (CAGR) of just 1.14%. It’s evident the company has concentrated more on protecting its margins, rather than improving its sales volumes. At the same time, a large chunk of its earnings has come from ‘other income’ by selling assets and real estate. This, and not necessarily higher efficiency, has been a big reason for the big jump in profit that the company has posted in recent times. In fact, Pfizer, as most other pharma MNCs, adopts a very conservative policy in India, as it has a limited product pipeline.

Hotel Leelaventure: A humongous over-dependence on its Bangalore property, which contributes almost 50% of its EBITDA, makes Hotel Leelaventure a very tricky bet. With a large number of new premium hotels coming up in the region, there’s now almost a glut.

This will almost certainly drive down its average room rate (ARRs). Add to it the fact that its biggest customer — the IT sector — is now going through a very challenging phase and you have all the reasons to question the wisdom of buying this stock. Moreover, with a large amount of debt on its books, Hotel Leelaventure may find it difficult to sail through the upcoming economic slowdown. In fact, a much bigger Achilles heel is the large amounts of land that it has recently acquired at exorbitantly high prices.

Danger Zone

HCL Infosystems : HCL Infosystems operates in an overly competitive, as well as highly price-sensitive segment of computer hardware and office automation products. While in high-end products, it faces tough competition from multinationals like HP, IBM and Lenovo, when it comes to low-end products like desktop computers, local assemblers, with their cheap products, pose a big threat.

As a result, HCL’s operating margins have been declining consistently for the past four years and now, even sales are stagnating, as is reflected in its March ’08 quarterly results. The business model of its other sources of revenue, networkrelated hardware, is not very competitive and may not be sustainable in the long run.

Shree Cement: Traditionally known for being a financially conservative company, Shree Cement has raised a lot of debt in the past three years in order to fund its aggressive expansion plans. Its debt-to-equity ratio has touched 2 for the first time in the company’s history. In an era of rising interest rates, this means bad news, if seen in conjunction with stagnant cement prices.

The company reported an over 900 basis points decline in operating margin during June ’08 quarter, while its interest coverage ratio declined to 7 from nearly 30 a year ago. The company reported a marginal decline in net profit during the first quarter, even though its topline grew by 40% on account of higher volumes. This trend is expected to worsen further in the forthcoming quarters, putting further pressure on the stock.

Laxmi machine works : Being India’s leading textile machinery manufacturer, Laxmi Machine Works was the biggest beneficiary of an investment boom in the domestic textile industry, following the global phase-out of multi-fibre agreement in January ’05. With the boom over, projects are now difficult to come by, which has put a huge pressure on the company .

Its net sales and net profits declined for the first time in June ’08, possibly indicating the beginning of a very challenging phase. In the first quarter of FY09, the company’s net sales fell by 5%, while net profit was down by 3% over the corresponding period last year. Future outlook seems even gloomier if you consider the fact that if it were not for a generous 45% rise in other income, the company’s net profit would have declined by 20% during the quarter.

Maruti suzuki: With interest rates heading northwards and economic growth decelerating faster than expected, Maruti is probably headed for one of its most challenging phases. The company reported a marginal 0.1% growth in domestic sales during July ’08, against 22% volume growth in April ’08 and 12% growth during the first quarter. At the same time, input costs are rising steadily as prices of steel and power are continuously trending up. This is squeezing the company’s profitability from both sides.

In the first quarter, the company’s operating margin was down by nearly 500 basis points and profit declined by 7%. This was despite a 21% growth in net sales and 47% growth in other income during the period. Going forward, Maruti’s stranglehold over the small- and medium-car segment, which accounts for a bulk of its revenues and profits, is expected to loosen considerably as a result of new products from competitors like Tata’s Nano. All this puts India’s largest car maker on a sticky wicket.


via ECONOMIC TIMES